Audit Reform

Warning – unstructured thoughts ahead.

It feels that barely a day goes by without the relentless banging drum of audit reform in the media. Yesterday was no exception with the FT reporting another article. This time about ‘breaking up’ the Big 4. For some reason, people think I’m a knowledgable and reasonable chap(!) and ask me my thoughts about this topic. My answer is that the proposal for breaking up the Big 4 is stupid. It would actually make things worse. Here’s why.

The proposal

In short, the idea is that the accounting firms would separate their audit functions from the rest of the business. Currently, they sit together under an umbrella Limited Liability Partnership (LLP).

In a LLP, the Partners share the total profits and equity of the firm according to a written agreement. Each partner is liable up to the amount of equity they have in the business (thus the limited bit, unlike a regular partnership where liability is unlimited).

But

This simplistic change belies an ignorance of how the accountancy firms (and frankly, most companies) run today.

Firstly, it ignores the massive amount of shared services in the firm. IT, facilities, cleaning staff, security, HR, legal. The list goes on and on. Right now these services are shared between the audit function and the other departments. And whilst there are obviously differing allocations between departments, the split is relatively easy to do as things are internal.

Now if the big 4 were to be broken up – what do you do with those shared services? The first option would be to have them sit in one firm and then charge out to the other. This runs into the potential incentive to cross-subsidise one or the other business with under/overcharging.

For those (un)fortunate to come across Transfer Pricing – this is an absolute minefield.

The other option would be to create a separate legal entity where all the shared services sit. The audit and non-audit firms would then buy IT etc. from the services company.

In practice, some of this already happens today. But the scale of moving the entire operations department of some of the largest companies in the world cannot be underestimated.

It would take years and likely hundreds of millions of pounds. And the accountancy firms aren’t in the business of charity – that cost would be passed on to their customers and ultimately you and I.

The bigger problem

But this misses the bigger problem. Auditors rely very heavily on subject matter experts to do an audit. If you’re auditing a FTSE 350 company you may need expert input from experts in valuations (me), IT, cybersecurity, forensic accounting (also me), real estate, tangible asset valuation, pensions, banking and covenants, financial instruments as wall as industry experts, economists, restructuring experts.

Auditors are trained professionals but they do not have the expertise to critically evaluate actuarial assumptions, discount rates or know the resale value of the widget master 3500max.

To give an analogy GPs are trained doctors, they know lots of stuff about a lot of things but they are not a specialist. If they think you have cancer they send you to the radiographer for scanning and then, if you’re unfortunate, the oncologist. The same happens with audits.

Right now, if the audit team has a valuation issue they would pick up the phone to the valuation team, or drop an email. It’s quickly solved and time cost simply added to the audit matter.

Perhaps you can see the problem. If you hive out audit from the rest of the accounting firm’s expertise you will create a barrier to that getting expert advice. It will take longer to get that advice. It would be more costly. Just erecting a tiny speed bump may incentivise auditors to ‘not bother’.

That is the biggest worry. Auditors doing discount rates is like watching a cat try to juggle.

Taking a step back

I think we are getting ahead of ourselves though. My feeling is that we are trying to solve a problem before diagnosing what we are trying to fix.

For me, there are two distinct but related problems:

1. Companies failing

2. Poor quality audits

Companies failing

Taking the first – Why do companies fail? Because of bad management. Auditors do not cause companies to fail. Whilst bad financial reporting may exasperate corporate collapses, it does not start them. So if we want to tackle the problem of companies failing, we must focus on management.

As a country, we are a soft touch on bad execs. This isn’t, as many politicians would have you think, because of poor regulators. Rather, it’s because our regulators have not been endowed with strong enough powers to get tough on poor management (by, funnily enough, those same politicians).

I back a stronger and more heavily resourced regulator who looks into all corporate matters (right now, accountants and lawyers are heavily regulated by their own professional bodies but those who are neither are not). This is something that almost all regulators I’m aware of having been begging for years. Their pleas falling on deaf ears.

We can look over the pond to what we should aim for: the Securities and Exchange Commission (SEC). Send a silly tweet – they’ll go for you. Whilst expert finance commentator Matt Levine is being a little tongue in cheek, in the US everything is Securities Fraud (this is my favourite recent example).  This is the zero tolerance approach we need.

But it involves Westminster and Whitehall relinquishing control. The mooted replacement for the Financial Reporting Council (FRC) the Audit, Reporting and Governance Authority (ARGA) is a start. However, I strongly doubt it will be enough.

Tackling poor quality audits

Getting tough on audits isn’t going to stop companies failing. But something needs to be done. The much-maligned FRC has said so itself. Poor quality audits hurt everyone. Investors, employees, suppliers, communities, the Government and society-at-large all rely upon financial reports to make decisions.

This is the key – oft forgotten – the Statutory Audit is a public service. I feel a large part of the problems with audit is down to this collective amnesia. Audits are vital for our economy and society. As such, they need to be treated with respect. It’s this lack of respect for their importance that has led to standards slipping. How do we fix it?

Three steps for better audits

Management should not choose the auditor

First, the way audits are procured is a huge problem. Management selects the auditor. Their focus is on two things: cost and minimising hassle. This has led to minimising cost at the expense of quality. Similarly, it means that the audit partner’s primary focus is on winning/keeping clients and not on making sure their audits are up to scratch. That’s because their pay is based on work won. Not on the quality of work performed.

We can solve this by taking management out from selecting the auditor. Instead, we should have a public body (maybe called the Audit Panel). When a company needs a Statutory Audit, the Audit Committee of the company completes a standardised form setting out its audit requirements (industry, size, scope, specialist expertise required). This is based on the findings of the Internal Audit function. On completion, it’s sent to the Audit Panel who then sends a request for tender to the accountancy firms that it has in its database. Each tender is judged on set and defined criteria including cost, expertise, experience, but most importantly, audit quality. If your firm has been doing bad audits, expect less work. The Audit Panel publicly selects the winner and the reasons why they won.

Whilst this might sound a bit of a bureaucratic nightmare, I feel it necessary. I think it’s crazy to have the decision on who performs the Statutory Audit for a company, a public service that could affect millions of people, hidden away in cosy boardrooms.

Reform the purpose of the Statutory Audit

The purpose of the Statutory Audit has remained almost unchanged for decades. Despite the rapid change in society and our economy. Auditors still sign off whether the accounts are “true and fair” despite this phrase not being defined. It’s one of those things where we’re supposed to ‘know it when we see it’. But this belies the fact that our world is more complex.

The Companies Act (which sets out things such as the Statutory Audit) was last updated in 2006. Before Smartphones, Facebook, Social Media, the Cloud. Prior to the Financial Crisis, the FCA and PRA, many iterations of IFRS ago and well before new UK GAAP. It’s out of date and needs updating. It needs to be more prescriptive. A more robust framework for audits is required and stronger punishments when that framework is not adhered to. Unfortunately, that requires our MPs to stop d*cking about and actually do some work. So the odds of it happening is low.

Respect auditing as a profession

As audit is a public service we need to respect auditing as a profession. By this, we must acknowledge its importance to society just as we do for doctors, lawyers, civil servants, policeman and teachers. The current situation is devaluing the role of an auditor.

Most accountants spend three years at a firm (often the Big Four) in audit. They are given the dogsbody work. These days often glorified box ticking and form filling. A sorry unintended consequence of heightened regulation. The art and skill of auditing have been taken away.

Once the three years are up, most leave. Going into the industry (i.e. in companies) or moving to more interesting and financially rewarding jobs in corporate finance and consulting. I know this, as most of my old colleagues were ex-auditors. They’d tell me the stories of drudgery, late nights and tight deadlines. Boring work under time-pressure – a sure-fire way for things to go wrong. Sure, audit isn’t all doom and gloom but life is relative.

If we’re serious about making audit great again, we need to be making auditing a profession to aspire to. It has to be intellectually and financially rewarding – not a pygmy sibling of consulting, banking and corporate finance. This means making the training contract (the three years of work and study) more engaging. It also potentially means taking some or all of the training requirements away from accounting firms.

A final note, the regulators in the UK are vulnerable to regulatory capture. That’s because a very large proportion of today’s accountants trained at one of the Big Eight (Andersens, Arthur Young, Coopers & Lybrand, Deloitte, Whinney, Peat Marwick, Price Waterhouse and Touche Ross). Over time they consolidated down to four firms (Andersens going bust, their diaspora roaming the financial services landscape). A similar process has happened with the mid-tier firms hoovering up practices. This means it’s hard to find any company without several alumni of the Big Four (even if they left the predecessor firms many years previous). Reforming the audit profession should also look at softening the vice grip of the Big Four on trainee accountants.

A final word – conflicts

I’ve rambled on long enough, but you may notice I haven’t mentioned conflicts of interest. Despite it being the headline grabber, my experience having worked in corporate finance both in the Big Four and at a non-Big Four firm is that conflicts are less of an issue than made out. The Competition and Markets Authority agrees with me.

Working in corporate finance we were simply not allowed to do any work for companies audited by the firm. Things got even more extreme for US-listed companies. My basic understanding of why I constantly lost work through conflicts was that if the audited company once farted in the same room as my potential client I couldn’t do the work.

I can’t speak for Audit or Tax, but conflicts were taken very seriously both inside and outside the Big Four. As an accountant, I have a duty to act on both actual and perceived conflicts. This is why you often see us get quite prickly about it. That’s because more sabre-rattling by MPs means greater perceptions of conflicts, even when there aren’t any actual ones.

This is the reason why, since post-Enron when consulting was hived off from audit (because of actual conflicts), we’ve seen the gradual creep of consulting back into the Big Four. From my experience in Corporate Finance, I’m sceptical that this has created an actual conflict, but over time the perceived conflict has grown.

That said, it’s more challenging with Tax services. That’s because tax and the audited financial statements are heavily intertwined. Selecting a different firm to do your audit and tax work means duplication of effort, more time and more cost. When the decision lays in the hands of management (as I’ve said above, I don’t think it should) then plumping for the same firm to do both the audit and tax work makes rational sense to them. Especially given our overly complicated tax system.

However, I don’t think any accounting professional worth their salt sits there and thinks: “I’m gonna do a bad job because someone else in the other office is also doing some work on this client.” Certainly, I never thought about that, only ever focussing on doing the best job I could on my project. I don’t think tax specialists are a different species from forensic accountants (though they are pretty odd).

Anyway, that’s enough from me. Apologies for the ramblings.

All the best,

Young FI Guy

p.s. for disclosure, I worked as a forensic accountant and corporate finance specialist at the Big Four for several years. I also worked at a non-Big Four for several years. Thankfully, I never worked in audit. I qualified as an ACA without having to do a day’s worth of audit work. Instead, my career mainly seemed to be clearing up the mess after bad audits…

p.p.s. I had half-written this out in a draft but wasn’t going to post it. However, Mrs YFG got so bored of me ranting on that she told me to upload this and leave her alone. So you can blame her for this boring post.

p.p.p.s. I’m really sorry if you actually read all this.

7 thoughts on “Audit Reform

  1. This starts with a simple question: why audit? Way back in my accounting days they taught us the purpose of an audit was to ensure the existence of a process, then validate the evidencing that the process was followed.

    Not to write those processes.

    Not to say whether a process made sense, or was adequate.

    Not to comment on whether the client’s business model was on the fast track to insolvency, or the company was run by raving loons.

    Just to ensure the existence of a box, and that a timely tick had been placed within it.

    Essentially this is asking an “objective” third party to validate the client had completed their homework, but not whether that homework had been done correctly.

    Audits delivers little direct value to the client themselves, the work product being intended to assure interested third parties that the client follows their own processes.

    When viewed through this simple lens audit is a non-competitive service, like the law courts or building inspectors or sewerage pipes.

    The audit providers essentially offer a commodity white label service, only differentiated by marketing. This is why the market has consolidated to the current oligopoly. If it wasn’t for competition policy, it would be a natural monopoly.

    By contrast tax work adds considerable value to clients. Creative accounting, tax minimisation, and exploiting legislative weakness is a very competitive endeavour and tangibly adds to the client’s bottom line.

    I agree the audit profession gets unfairly blamed for a lot of things due to wide held misunderstandings about their reason for being. That said, the firms don’t paint themselves in glory by regularly undercooking bids and then doing half-assed jobs in an effort to defend their margin.

    For mine, the provision of external audit services should be operated by the regulator, in a similar manner to how HMRC oversees tax audits. The regulator could outsource the work to audit firms, but remains accountable for the quality and outcomes. That removes the conflict of interest from firms not wanting to bite the hand that feeds them, while potentially extending your economies of scale argument for accessing expertise.

    1. I’m surprised that’s what/how you were taught – very different to myself which was couched in CA06 and ISAs. Maybe due to differences in time and geography?

      But yes, I agree with you on pretty much all the rest. Especially on audit being a natural monopoly.

      I’d caution against saying auditors undercook their bids. I know this has been a topic in the press, but I don’t agree. When I looked at the data and the auditors recovery rates, I would have definitely taken them on my jobs! Unfortunately, scope creep is an issue throughout financial services. Something we were warned about, but never really armed to deal with. But it’s much the same as my builders who have found I’ve changed my mind on things or need a few extra things doing (or Crossrail or NHS improvements or housing developments etc. etc.) Ideally, we’d underpromise and overdeliver – something I always tried to hold myself to. But I think I’m in the minority on that when it comes to professional services (or perhaps any walk of life). I’m sure you deal regularly with clients who change their mind like the weather!

      1. Scope creep is another way of saying undercooked bid.

        Audit firm says “we’ll do the audit on a fixed time and materials basis”, client then buries auditors in paper and complexity to try and obfuscated dodgy practices. Defending margin reduces audit sampling rate, lengthening the odds of the auditor stumbling onto the noncompliance.

        Audit firm then faces the choice of throwing bodies at the job (eg the ubiquitous army of cannon fodder grads) to do it properly, or rolling the dice risk wise.

        Partner gets a nice bonus if the gig is profitable, while missing a big risk that subsequently becomes an issue is career ending regardless of the margin. So there is a commercial incentive to keep rolling the dice until the gig is up.

  2. “making audit great again”: very droll.

    I’m not much taken with your reference to the SEC. I have the impression that the US federal government is more and more a big shake-down organisation, exploiting its coercive powers, and its corrupt prosecutors and courts, to exert arbitrary power. Not the ideal model for us.

    1. Thanks dearieme. I’m quite proud of that one…

      I’m sympathetic to that. The US is well known for its dubious practices (asset forfeiture seems to be one of the most ethically questionable – literally a legal shake-down). There’s a balance to be struck. I think at the moment, we are on the wrong side of the balance. You need only look at the omnishambles of London Capital & Finance to see our attitude to nailing bad dudes isn’t working.

      On the other hand, stricter regulation doesn’t always work out best. Thinking back to my work days, the audit advisory work for US regulated companies was a pain. We’d do exactly the same work, but it would take three times as long because we would have to fill out a bunch of forms and tick certain boxes. The client got no better service (at least from my end), just a bigger bill.

  3. Really enjoyed the article.

    When I trained as a CA (Big 6, c30 years ago) things were very much as Indeedably says. The job was to make sure the (now historical) accounts were “true and fair”. The fact that the business model might be rubbish, the management barely sentient and the results woeful was irrelevant (so long as the company could still be justified as a going concern at the date the accounts were signed off).

    All the big accountancy firms have business advisory departments that will help (although I doubt many of their practitioners have actually run a business). However that’s not the audit department.

    I suspect that in the eyes of the general public the role of the auditors is to comment on how “good” the business is and what its prospects are – to help the shareholders / interested readers / journalists judge the business model, trading conditions, and management quality. And, for good measure, to sniff out fraud.

    You COULD get the auditors to write 1,000 words on these things at the end of the Audit Report, but I doubt it would do much more than support the management’s position. There was always enough of a grumble over the most innocuous disclosures. I hate to think of the rows if the auditors were to say that the pricing model was poor, or that the expansion plans were a bit “ambitious”. “What do you know about our business?” would be management’s rejoinder.

    Generally I think audits fulfil their requirements quite well (for a knock-down price). However I think the problem is a mis-match between what the auditors are hired to do (which is prescribed by CA06 etc) vs what the wider world wants them to do (or, indeed, thinks they should be, or are, doing already).

    I didn’t mind auditing so much (but went to be accountant in business shortly after qualifying). But I never thought for one moment I was commenting on the quality of the business, business decisions, models and practices, nor of the future prospects of the company or the quality of the current management. Just wanted to be sure Trade Debtors were fairly stated, and those pesky directors loans were disclosed… It was up to others to determine how “good” the company was, and for that you need a lot more that a set of last year’s statutory accounts.

    And when I was an FD I never thought for a minute any non-involved person could really understand our historical business (never mind our future prospects) from the statutory accounts.

    1. Thank you Richard, and thank you for sharing – really interesting thoughts.

      I’m with you on the difference between what an audit is and what it actually is. I used to often say that people think an audit is done like a forensic accounting engagement when it isn’t. I used to talk about this more, but then the GT exec really stepped in it. Personally, I think his comments were very damaging to the industry.

      One of the issues is that an audit is backwards looking like you mention, but these days so much of the balance sheet is based on future forecasts (Goodwill, internally generated assets, accrued income). So I’m sympathetic with the confusion, but it still stands that the Financial Statements are a historical snapshot in time. As you rightly point out, there is that mismatch between what CA06 says needs to be done and what society wants doing.

      You gave me a wry smile at the ‘expansion plans are ambitious’. Management are always liable to rose-tinted glasses. I don’t think that’s a bad thing (I’d be worried if the company’s management were doomy and gloomy about their future prospects). A really interesting part of my job was learning about new industries – trying to build 30 years worth of knowledge in 3 weeks. Obviously, you can never replicate experience but over time you learn about the right places to look and the questions to ask.

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